Earlier this year I wrote a blog piece about whether UK interest rates would change and if so, in which direction would they go? There was, at the time, a reasonable case for rates increasing, thus beginning the process of 'normalisation' of monetary policy. At the same time, there was a real question of whether rates could be lowered, with the Bank of Japan joining a select band of central banks which had already set negative rates.
This marked a crossing of the Rubicon from ZIRP to NIRP, or 'zero interest rate policy' to 'negative interest rate policy' (Economists do love their abbreviations!).
The objective of really low interest rates is clear - to make the cost of borrowing very low so increasing the ability of households and firms to boost expenditure.
Ordinarily, under positive interest rates we would measure the opportunity cost of holding cash as interest forgone. Under negative interest rates, banks are charged an interest rate on deposits at the central bank. To preserve profit margins they may pass that on in the form of bank charges to a retail customer; this would incentivise the retail customer to minimise cash balances at the bank and use cash where possible.
Has it worked? Well, we are effectively in uncharted waters. If households are penalised for holding cash at a bank, yet there is little opportunity or desire to consume, then why not keep it at home? If this seems a little extreme, according to Deutsche Bank economist Torsten Sløk sales of fireproof safes in Japan have rapidly increased since the introduction of negative interest rates due to consumers wanting to keep cash at home.
This has been borne out by figures on cash holding too.
"The total amount of cash stashed at home is estimated to have surged by nearly ¥5 trillion to some ¥40 trillion in the past year, Hideo Kumano, chief economist at Dai-ichi Life Research Institute, said."
(The Japan Times 7 April 2016)
Now some of this may also be due to Japan introducing a form of identity number, so there may be an element of shielding assets from government view. Nonetheless, hoarding cash rather than seeing it spent or invested in other assets seems strange to us as this is not a normal state of affairs. To judge how this is an emotional reaction, the FT quotes a Bank of Japan official;
"We think the public now understand that deposit rates will never be cut," says a BoJ official. It is happy to highlight statistics showing the impracticality of safes, noting that ¥100m in ¥10,000 bills weighs 10kg and fills a physical volume of roughly 12 litres — bigger than the safes on sale in many shops."
(Financial Times, June 17, 2016)
This is very interesting as a response by ordinary households – especially considering that negative rates were not imposed on retail deposits but rather excess reserves held at the Bank of Japan by Japanese banks. What might be behind the reluctance to transfer cash into other assets or consumer good? Again we turn to the FT:
"In theory, negative rates will stimulate the economy … the reality is that people just feel very uncertain for the future. It will take some time to understand the real benefit."
And there's the key; we are seeing an emotional reaction to these negative rates and this is nullifying their impact in terms of their desired effect on investment expenditure and consumer spending.
The Bank of England - too much too soon or too little too late?
How does this relate to the UK? At the recent August meeting, the Bank of England has reduced the base rate to a record low of 0.25% (amongst a range of other changes too). This was not unexpected after the referendum result, but the timing of the move has caused some debate. The lag between a change in the interest rate and the impact on GDP is about 12 months; with this in mind the Bank of England may think it is better to make policy changes now rather than wait and see if Brexit impacts emerge and then react.
Even so, the rate cut has already had an impact, with two banks so far responding by cutting the rate on retail deposits; First Direct have cut the deposit rate on their cash ISA by 0.4% and deposit account by 0.3%. Tesco has followed suit with cuts of 0.3% on two of its' savings accounts.
In line with the Japanese experience above, this will reduce the incentive to save.
At the same time, mortgage interest rates have fallen to record low levels; two year fixed rate mortgages can be found for 0.99%1.
It should be pointed out that these mortgage rates may only be available for re-mortgaging and with other restrictions. Nonetheless, these represent very low rates of finance. Currently, very low rates are available for personal loans too. The effect of both of these should be to bolster activity in the housing market and allow consumer spending to grow particularly in consumer durables.
Whether this will be effective depends on the interest elasticity of consumer spending and investment spending. Some argue it will have little impact; rates are so low already that a reduction of 0.25% will be negligible (save in the bond markets; at such low base rates and government bond yields, the impact on the bonds price of a rate cut in a low yield environment can be substantial).
Will the rate cut, additional QE and extra funds set aside for banks be sufficient to offset any negative impact on consumers' and firms' expenditure arising post-Brexit? It will definitely improve their ability to spend, but that might not be the point. It might not be the price of finance nor the availability; it might just be the willingness to borrow that is the issue…The Telegraph recently reported "Manufacturers shunning bank finance and hoarding cash" (8 August 2016), with 55% of manufacturers reporting they had built up cash reserves post-Brexit and 35% saying they would cut investment if they couldn't fund it for their own resources.
Consumers too are decidedly less confident according to GfK with an 11 point drop in confidence since June.
This confidence level has bounced back somewhat in August as the initial fears about Brexit have dissipated; however, there is every chance it will display some volatility as the process of implementing Article 50 begins.
If consumers and businesses don't want to increase spending or take up additional finance, even at such low rates, then we may need another set of tools; over you at the Treasury for expansionary fiscal policy?
The Bank of England; damned if you do, damned if you don't.
Was the Bank of England right to throw so much weight behind accommodative monetary policy?
We won't know for some time and it really was caught between two stools. On the one hand businesses were looking for clear guidance from policy. In the excellent DeLoitte quarterly survey of CFO's in the UK, the most recent edition contained responses to the question, "what could the authorities do to support economic activity?", 91% answered 'Give a clear direction for the Uk's negotiations with the EU'.
On the other hand, the ex-politician and experienced fund manager John Redwood stated;
"Just a few weeks ago we were facing recession according to official forecasts if we voted Leave. Now we are told there will be little or no growth instead. These forecasts are very flexible, and doubtless wrong. The Bank should have waited to see proper data for output and activity for the first quarter or so after the vote before rushing in2."
Who'd be a central banker? In the meantime, The Bank of England has not ruled out a further rate reduction and RBS and NatWest have recently introduced negative rates for corporate borrowers. There is still much more to come as this story unfolds.
1. money.co.uk, 12th August 2016
2. http://johnredwoodsdiary.com/2016/08/04/bank-of-england 4 August 2016)